Even though there is no specific rule under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) for registered investment advisers to seek best execution when trading on behalf of their clients, most investment advisers understand that this is part of their fiduciary duty.
Generally, this understanding stems from the fact that over the years, the U.S. Securities and Exchange Commission (“SEC”) has issued numerous guidance outlining this responsibility. Two of the more recent examples include the following:
- Commission Interpretation Regarding Standard of Conduct for Investment Advisers (Release No. IA-5248 – July12, 2019)[1]
- SEC Risk Alert – Compliance Issues Related to Best Execution by Investment Advisers (July 11, 2018)[2]
In these releases, the SEC opines that investment advisers, as fiduciaries to their clients, have an obligation to seek best execution (i.e., looking for the best overall deal at the time of the transaction). Additionally, both releases state that advisers need to perform post-trade evaluations of the executions they receive for their clients. However, while the SEC has issued guidance on these obligations, they have not issued any specific requirements outlining how an adviser can satisfy their fiduciary duty. As a result, investment advisers often remain uncertain about what specific factors they need to consider and review.
In this risk management update we discuss some of the important factors and costs that need to be examined by advisers both when seeking best execution and performing post-trade reviews.
Seeking Best Execution
Specifically, in the 2019 Interpretation, the SEC stated:
“When seeking best execution, an adviser should consider “the full range and quality of a broker’s services in placing brokerage including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness” to the adviser. In other words, the “determinative factor” is not the lowest possible commission cost, “but whether the transaction represents the best qualitative execution.””
Importantly, the process of seeking best execution doesn’t begin when the trade is being placed, it begins when a firm is deciding which brokers and/or custodians to use. For example, an investment advisory firm that wants to use a custodian advisory platform, such as the ones offered by Schwab, Fidelity, and Pershing,[3] will need to consider more than just the range and quality of brokerage services. Since the investment adviser using the platform will be recommending the specific custodian to their clients to provide both custody and brokerage, they need to also look at the custodial services offered and even compare them with other custodian platforms.
Under this type of platform, an investment adviser will generally place trades with the brokerage arm of the custodian for execution. This is mainly because the custodian does not charge a custodial fee when clients’ trades are placed with them. Additionally, the transaction fees/commissions are lower under the advisory platform than the amounts charged to retail clients. However, when considering this type of arrangement, investment advisers need to request and examine the custodian’s prior execution performance, trade routing activity, and trading costs vs. other similar broker-dealers.
In some cases, a custodian may offer “trade away” capabilities under a prime brokerage arrangement. This allows the advisory firm to place certain trades for execution with a non-affiliated brokerage firm and then have the transaction settle through the custodian. This is mostly utilized by advisers when the custodian does not have the securities inventory needed, such as certain types of bonds, and/or the adviser believes they can obtain better execution outside the custodian for certain trades. When implemented, the client usually has to pay both a commission or a marked up/marked down price to the executing broker-dealer and a trade away/prime brokerage fee to the custodian. Therefore, investment advisers should look at what access they will have to various types of securities, and when applicable, what the additional costs for their clients would be under a prime brokerage arrangement and compare those to other custodian offerings.
For investment advisory firms with clients that have selected their own custodian and provide the firm with full discretion to trade with any broker-dealers, seeking best execution requires different considerations. Usually, in this situation, investment advisers create a list of “approved” broker-dealers they will work with, and a large part of the approval considerations revolve around the research and brokerage services (i.e., trading and settlement) they will receive. While that is acceptable as a base, there are other factors, both qualitative and quantitative, that also need to be considered. As with custodian platform arrangements, investment advisers with brokerage discretion need to look at a broker-dealer’s prior execution performance, trade routing activity, and trading costs. In these situations, the investment adviser has the ability and usually does negotiate commissions, which is why it is important for the advisory firm to have one or more designated knowledgeable traders that are given the authority to “work” the trade. In other words, the traders have the ability to independently select any brokers from the approved list and place trades based on where they believe the best trade execution can be obtained.
Additionally, under both types of trading arrangements, advisers should review the broker’s financial strength and stability, reputation, efficiency in correcting trade errors, and promptness in providing executions.
Post Trade Reviews
In the SEC’s Risk Alert on investment advisers’ best execution practices, one of the common deficiencies they list is that advisers are not performing best execution reviews, and for that they stated the following:
“The staff observed advisers that could not demonstrate that they periodically and systematically evaluated the execution performance of broker-dealers used to execute client transactions. For example, the staff observed advisers that did not conduct an evaluation of best execution when selecting a broker-dealer to execute transactions or were unable to demonstrate, through documentation or otherwise, that they performed such an evaluation.”
Just as seeking best execution has many components to consider, determining whether a firm obtained best execution is not just looking at the execution price and transaction costs. However, that is not to say that these two items are not important, and they should be reviewed in detail. For example, advisers that trade equities, bonds, options, ETFs and the like should perform an analysis of a sampling of executions received by the firm against an appropriate benchmark, such as volume weighted average price (VWAP) at time of placement and execution or even the day’s VWAP. If VWAP is not available, then compare with the open, close, high, low, prices of the specific securities for the trading days being reviewed. While this is a type of forensic review, with the results needing to be viewed over a period of time to determine if there is a patten developing, it can also show when any specific trade is outside the range of the benchmark, prompting an inquiry as to why. When reviewing the costs of a trade, it is necessary to look at all relevant costs, including transaction fees/commissions, costs pertaining to specific types of securities (e.g., mutual fund expenses), and any other applicable trading and settlement fees.
Post-trade reviews should also include consideration of soft dollar arrangements, trade routing activity, and any trade errors and corrections. Analyzing the performance of any trading software that has built-in algorithms is also a must.
The frequency and timing of the reviews and the personnel responsible tend to vary depending on size of the firm, types of securities traded, trading volume, and whether the adviser uses a custodian advisory platform or trades with numerous brokers. Suffice to say that a firm that performs a large amount of daily trading and utilizes various brokers should probably perform post-trade reviews on at least a quarterly basis, while a firm that uses a custodian advisory platform and trades mainly in open-end mutual funds would only need to review annually.
Conclusion
There is a lot of work that investment advisers must perform in order to meet their fiduciary obligations pertaining to best execution, and the information outlined in this update is only a summary. Advisers also must document the performance of all the work, along with the results, and maintain as part of their required books and records. In addition to all this, firms must have detailed policies and procedures outlining their best execution process and ensure they have detailed and accurate disclosures in their Form ADV.
The Core Compliance consulting team is well versed in the area of trading and best execution and can assist firms with performing trade analysis and best execution reviews, in addition to drafting policies, procedures, and disclosures. We also offer compliance technology solutions, which are crucial for helping maintain documentation and ensuring adherence to the voluminous amount of regulations that are applicable to investment advisers. For more information, please contact us at info@corecls.com, at (619) 278- 0020 or visit us at www.corecls.com.
Author: Tina Mitchell, Managing Director, Consultation Services; Editor: Matt Rothchild, Sr. Compliance Consultant, Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, and private fund managers on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon regarding any particular facts or circumstances without first consulting with a lawyer and/or tax professional.
[1] See https://www.sec.gov/files/rules/interp/2019/ia-5248.pdf
[2] See https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20IA%20Best%20Execution.pdf
[3] Not all inclusive.